November 23, 2020
by Bal Katlai, PhD, CPA, CGA; Waji Khan, B.Sc., DDS, MBA, M.Ed., FICOI, FPFA, FICD, FACD
An important consideration during the sale of a practice is the amount of taxes arising from realizing a capital gain – the underlying asset primarily being the patient list, i.e., goodwill. While the seller can avail of the lifetime capital gain exemptions as a reduction to the capital gain tax, there are opportunities for a tax deferral. As it turns out, depending on the circumstances of the seller, a few tax deferral options for the seller exists, such as capital gain reserves that delays payment of taxes upon a sale or an estate freeze that can follow a sale transaction and part of a succession plan. An important tip is that any tax planning should always follow a business or life objective.
To illustrate, consider John who has a successful dental practice (“Dentalco”) and is contemplating a sale subject to satisfactory sale terms. John is happily married with two children – it is unclear whether any of the kids may become a dentist and acquire the practice from John but this option is not ruled out. With this simple and limited fact pattern, what options does John have when considering a sale of his practice?
Terms of a sale:
John wants to ensure that his prospective buyer aligns with his business objectives and vision – and to facilitate this, it was decided that there will be a phased pay-out of the practice. While this satisfies John’s desire to make sure the Dentalco values and vision is preserved and smoothly transitioned, on the tax side, this allows John to evoke a capital reserve wherein the practice payout can spread up to a period of five years. This approach gets John a tax deferral and eases the tax burden following a sale. Such a measure also allows for better managed shareholder and management compensation which can be structured for additional tax deferred payouts and further can be a win-win situation for the prospective buyer. The actual time of carrying a reserve can be part of a sale agreement and gives a flexibility to meet business goals and a tax deferral option.
Another option for John is to consider a contingent liability for being renumerated upon the sale of Dentalco. Here, a contingent liability is a liability that depends for its existence upon an event that may or may not happen. The test is if there will be an existence of a legal obligation at a point in time that is subject to the occurrence of an event – this could be the buyer meeting a certain milestone in revenue. In such a case, John will report an income for tax purposes only when the event has occurred. John could also set up a separate corporation to receive the considerations from seller and based on the timing of payment – both John and the corporation can defer taxes on the income received. While this is similar to a reserve discussed above, it differs in the sense that the earnout can be either a capital or income in nature depending on the terms of the sale agreements.
Accrued Bonus payouts
Another aspect that is sometimes discounted is the ability to offset generic employee salaries with bonus payouts – this can allow for tax deferral, and further reduce the corporations tax debt on account of deductions due to bonus payments. An approach that John can consider is the notion of a bonus accrual. For instance, Dentalco can opt with its employees to make a higher cash payout in lieu of a (say a lowered) salary for the particular year of sale. This can be based on the sale agreement and be in the form of a lumpsum bonus pay day. If so, Dentalco must pay out such a bonus it declares in a fiscal year within 179 days of the end of its taxation year – the employees of Dentalco (which can include John and any family members if lawfully employed) can benefit from a helpful tax deferral to the year when the amount is received. As an example, Dentalco can declare and accrue a bonus on December 31, 2020 (say its fiscal year and a date close to a sale date) and pay the amount as of May 2021, and the recipient employee is not taxable until calendar year 2021, with the tax payable in 2022. However, Dentalco must pay its withholding taxes which limits the deferral benefit but is nonetheless useful for John and his employees.
Succession within the family
In the case facts, it was unclear whether the children of John are interested in being practice owners – if there is an opportunity for this, then John can consider the option of selling the practice within the family and seek out a capital gain reserve over a ten year period (as opposed to a five year period when sold to a third party arm’s length buyer) – while this may or may not align with John’s financial needs, it may align to retention of the business within the family (if that’s an option) and a prolonged tax deferral for John. As part of such a family succession, the amounts paid to John on a reserve basis can be part of an estate freeze plan – the benefits of this being, John can consider a wasting of the freeze plan to draw an income based on his needs which will imply a deferral to a future period when the income is drawn. This also has an added advantage of lowered estate taxes post John’s death and is a useful part of a post-mortem plan.
Disclaimer: This article is for educative purposes only and is not a substitute for tax planning or advice. Always, consult your professional tax advisor before undertaking any tax planning or transaction.
About the Authors
Bal is a tax practitioner based out of Toronto and has been assisting clients for more than a decade. He specializes in tax planning and advisory for owner-manager business. Bal can be reached at: email@example.com
Waji Khan, B.Sc., DDS, MBA, M.Ed., FICOI, FPFA, FICD, FACD. Dr. Khan is a dental Surgeon based out of Toronto. He can be reached at: firstname.lastname@example.org